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The Wages of Subsidy: Searching for Value in Public-Private Development Deals

Los Angeles Daily Journal, August 9, 2011

Developers who acquire land from public agencies at discounted prices or rents are often surprised to learn that their land acquisition may trigger prevailing wages, pay rates roughly equivalent to union scale wages and benefits, often significantly higher than non-union wage rates. Having to pay prevailing wages is regarded as a tradeoff for the receipt of a public subsidy for a development project.

Public agencies commonly sell and lease land to developers for public-private development projects. Sometimes the agency charges the developer the same price that a private landowner would demand, and at other times the land is conveyed for deep discounts for projects that generate low returns, such as affordable housing. Because public-private land deals often contain costly development requirements, it’s not always so clear whether the developer is truly receiving a subsidy or is paying what the land is worth. That is the heart of the dispute in a recent appellate case imposing state prevailing wage requirements on a hotel developer who leased a project site from the San Diego Unified Port District, when the lease contained multi-year rent credits.

In Hensel Phelps Construction Co. v. San Diego Unified Port District, 2011 DJDAR 11191 (July 26, 2011), the port district issued a request for proposals (RFP) for construction of a 1000 plus room convention hotel on waterfront property owned by the district. The RFP term sheet envisioned that the land would be ground leased with the tenant paying percentage rent to the district, a minimum of $2.25 million annually during the first two years of construction and a minimum of $4.5 million annually for the next 18 years. The district then entered an option agreement with the selected developer that provided for the parties to enter a 66 year lease at the rent stated in the RFP.

In response to the developer’s request for the port district “to consider economically supporting the project,” the option agreement provided for the developer to receive a 60 percent rent credit for the first 11 years of the lease, with a value of up to $46.5 million. When anticipated construction costs rose, the developer requested “additional financial support” to offset the higher project costs, and the district approved an accelerated rent credit schedule. The lease that was ultimately signed charged the same rent contemplated in the RFP term sheet, but with a 100 percent rent credit for the first 34 months, and a 60 percent monthly credit until the total credit reached $46.5 million.

Two building trade organizations asked the state Department of Industrial Relations to determine if prevailing wages had to be paid for the construction of the hotel project as a result of the rent credit in the lease, and the DIR found that prevailing wages were indeed applicable. Prevailing wages are required under Labor Code Section 1720 if the project is “paid for in whole or in part out of public funds.” Leases can constitute the payment of public funds when they contain “rents…that are paid, reduced, charged at less than fair market value, waived or forgiven” by the public agency.

The appellate court viewed the $46.5 million rent credit as “reduced” rents within the “plain commonsense meaning” of the statute, noting that the genesis of the rent credit was the developer’s request for a “subsidy of $26.5 million to be paid by the Port District.” The court rejected the developer’s argument that there was no reduction because the rent payable by the lease itself was unchanged, finding that the rent credit contained in the lease itself constituted the reduction. The court did not find it necessary to examine whether the rent payable by the lease, together with the rent credit, represented fair market rent. Having to focus on fair market value would be “unnecessary and would greatly complicate the process” of determining the prevailing wage requirements, said the court, where the reduction is found in the body of the lease itself.

The San Diego case contrasts starkly to a 2006 DIR administrative ruling in which no subsidy was found to have been provided to a developer who ground leased land from the University of California for a 488-unit student apartment project on the UC Irvine campus. The lease required the developer to rent the completed apartments to UC students at below-market rates, and to construct expensive off-site infrastructure. The University’s appraiser found that the “as-is” fair market value of the site should be reduced as a result of the rent limits and off-site infrastructure requirements. A second appraiser then determined the market rent for the site based upon the first appraiser’s valuation of the land. Because the rent was determined through appraisals “using accepted methodologies by state certified appraisers,” the DIR found that the rent was set at a fair market level, with no prevailing wages required.

The difference in approaches to the two transactions is partly semantics, partly substance. The discussion of the UC Irvine project uses the language of value, detailing a careful technical approach taken by professional appraisers to determine the rent. The DIR opinion focuses on the use of recognized appraisal techniques to determine the market value of the land and the market rent with the restrictions in place. The consideration of lease requirements in valuing property is consistent with appraisal industry standards, which require appraisers to analyze the effect on value of the terms and conditions of a lease.

The court’s ruling on the San Diego hotel project, on the other hand, uses the language of subsidy, focusing on the hotel developer’s receipt of rent credits in response to its request for “economic support” from the Port District to compensate for high construction costs. The opinion creates the image of a developer looking for a handout of public funds rather than seeking the true fair market rent.

In each case, the rent was determined at a level that took into consideration the development and operational requirements imposed under the lease, and in each case the rent actually charged was lower than the rent that would have been charged if no development requirements had been imposed. The underlying concept is the same, illustrating that one person’s “developer subsidy” is another person’s search for true value.

The San Diego court’s focus on the rent credits contained in the lease itself is a rather unsatisfying attempt to take a bright line approach to the more nuanced question of value. Can there really be no negotiation of the level of rent set forth in the term sheet of an RFP without creating a “reduction” of rents that triggers prevailing wages? Do rent credits in a lease always constitute a payment of public funds, even when the total rent payable over the term is consistent with market rates? Free rent periods and rent credits are common in private leases, after all. Would the court really find prevailing wages required if the lease states the rent as $4.6 million with a 100 percent credit, but not find prevailing wages required if the lease states that rent for the year is zero? If the Port District had taken UC Irvine’s approach and set rents based on careful appraisals, which considered the value impact of the lease’s construction requirements, would including rent credits be regarded as a payment of public funds to the developer triggering prevailing wages?

Strange results occur when the court focuses solely on the “reduction” divorced from an analysis of market value. Perhaps future cases interpreting the prevailing wage statute need to move beyond the San Diego court’s “plain commonsense” approach in determining whether a developer in a public-private development transaction has received a subsidy or is really just paying the value of the land. Further, parties to public-private development agreements need to be cognizant of the language used in their documents and communications, as well taking an expert driven, value-oriented approach to the price of land being conveyed.

Jon E. Goetz is a land use and real property attorney at Kronick Moskovitz Tiedemann & Girard in San Luis Obispo who works with developers and public agencies on prevailing wage matters. He can be reached at jgoetz@kmtg.com.